Freeport-McMoRan - Asset Sales Buy Time And Optionality, But Impair Potential Upside As Well

Summary

Freeport is making progress with its divestment strategy in order to reduce debt and improve liquidity.

Asset sales and the issuance of equity improves the financial situation, but they limit the potential upside in a recovery as well.

After shares have seen a big rebound from the lows, I would be very cautious to join the momentum bandwagon, approaching the shares with a neutral stance.

Freeport-McMoRan (FCX) continues its aggressive divestment strategy, as it recently announced the sale of its interest in TF Holdings. The deal marks another major step in the efforts to reduce debt, increase liquidity and thereby improve optionality.

While Freeport is apparently willing to sell part of its core business, and I like the efforts to reduce leverage at fair prices, I am not very enthusiastic on the prospects going forwards. Its shares have already seen a big rally from the bottom. This move, the incurred dilution over the past year, and the still elevated debt load have structurally impaired the potential upside for shareholders in case of a decent recovery.

At current levels, I have a neutral stance on the shares, but certainly would avoid to join the momentum bandwagon.

Selling The TFHolding Stake

Freeport has agreed to sell its interest in TF Holdings, in an all-cash deal, which is valued at $2.65 billion. China Molybdenum, which is the buyer of the assets, will furthermore fork over an additional $120 million if both copper and molybdenum prices show a decent recovery by 2018/2019. Freeport is furthermore in talks with the Chinese business regarding the sale of refinery assets in Finland as well as exploration projects in Congo. These sales could potentially bring in another $150 million.

The deal is somewhat complicated given the different layers of ownership. Freeport holds a 70% stake in TF Holdings, which in its turn holds an 80% stake in Tenke Fungurume Mining. This implies that Freeport's effective stake in the operations amounts to 56%.

If you include the $120 million contingency payments, Freeport could get nearly $2.8 billion for its 56% stake, effectively valuing Tenke Fungurume Mining at roughly $5 billion. Based on Freeport's annual report for 2015, the mine holds 7.2 billion pounds of copper in reserves, with annual production coming in at 467 million pounds. Cobalt reserves are estimated at 874 million pounds, as annual production total 35 million pounds.

What About The Sales Price?

How does the $5 billion valuation of Tenke Fungurume Mining look like? The sale of 467 million pounds of copper, at an average price of $2.42 per pound, yielded $1.13 billion in sales for 2015. If you include the $287 million revenues from cobalt sales, total product revenues came in at $1.4 billion last year. This implies that the deal has been valued at roughly 3.5 times product revenues, although these numbers tell you nothing about the profitability of production.

Note that Freeport overall sold 4.1 billion pounds of copper in 2015, generating revenues of $10 billion in the process. If you include the revenues from molybdenum and gold as well, total product revenues from the mining activities came in close to $12 billion in 2015. If it would be appropriate to attach a 3.5 times sales multiple to these businesses, the entire mining business could be valued at $41 billion.

Again, this valuation does not take into account differences in terms of the profitability of each of the underlying assets. It should be stressed however that based on the reserve estimates, a $40 billion number for the overall mining business looks reasonable as well. The overall mining business has copper reserves being equal to roughly 20 years of current production. That is actually a greater number than the reserve estimates of the assets being sold. Its reserves are sufficient to produce copper at current levels for another 15 years.

Oil & Gas Assets, To Be Monetized? At Which Price?

The diversification adventure into oil and gas by Freeport has been often discussed and has been very painful for investors. The company spent $20 billion to acquire two large energy operators, taking on a significant amount of debt in the process. It is this debt which is causing the debt overhang concerns at the moment. On top of the considerations being paid for the oil & gas adventure, Freeport has made huge capital expenditures in this area as well in recent years.

The oil & gas assets produce roughly 150,000 barrels of oil-equivalent per day. Proven reserves amount to 380 million barrels of oil-equivalent. The company has already tried to sell or float the unit, but so far, has not succeeded. It is very hard to value this business at the current moment. Note that Freeport has spent roughly $20 billion to acquire these businesses, while capital spending has surpassed depreciation charges by multibillion-dollar amounts as well in recent years.

If you would generously attach a $10 valuation for each barrel in reserves, you would end up with a $3-$4 billion valuation for the unit. While other publicly traded oil and gas assets might trade at higher valuations in terms of reserves and production numbers, Freeport's assets are not great in terms of their quality, warranting a discount.

Looking At The Divestments So Far

At the end of the first quarter, Freeport held little over $300 million in cash while the total debt load had risen to $20.8 billion. The company's net debt load of $20.5 billion was actually up from the $19.8 billion reported at the end of the first quarter of 2015. Operational losses, and the fact that capital spending exceeded depreciation charges, outweighed the initial impact of the divestment strategy, as many deals yet have to close.

During 2015, the company has taken quite a few measures to improve the financial health of the business. The company announced job cuts and cut back on capital spending. In total, some $2 billion in new equity was raised, although the issuance has taken place at depressed prices. The company furthermore suspended its dividend, to avoid cash outflows in that area. Freeport furthermore announced the sale of a 13% stake in the Moreni Mine for $1 billion, alongside some minor other asset sales. All of these efforts and divestments have the potential to reduce the net debt load by roughly a quarter, as the pro-forma net debt load could fall towards $15 billion.

If we assume a $40 billion valuation of the mining assets, and a generous $5 billion valuation for the energy assets, Freeport's enterprise valuation would come in at $45 billion. Unfortunately, debt holders still have a claim of roughly $20 billion on the firm. If this $45 billion valuation is correct, common equity holders could potentially own equity in a business being valued at $25 billion. The trouble is that the shareholder base has been diluted by 20% over the past year, as Freeport now has 1.25 billion shares outstanding. That implies a potential valuation of $20 per share, again if this valuation is correct.

The trouble in my eyes is that this valuation might prove to be optimistic. The company has a difficult relationship with the government in Indonesia for its key Grasberg assets. The other problem is that while absolute leverage is going down, relative leverage ratios remain elevated. The other issue is the legacy of poor past decision-making. An example is the recent announcement that Freeport has to pay half a billion to cancel Drillship contracts with Noble (NYSE:NE).

If the $40 billion valuation of the mining operations indeed proves to be too optimistic given the issues in Indonesia, and some other issues, mining assets could be valued at just $30 billion. After adding $5 billion value for the energy assets, and subtracting the current net debt load of $20 billion, equity could be valued at just $15 billion. That translates into a valuation of merely $12 per share, roughly in line with the current level at which the stock is trading.

Caution Ahead, Fairly Valued

The fact that management is serious about the survival of Freeport has aided a revival in both the bonds and the share price of Freeport. Shares have recently rallied from a low of $3 in January to a high of $14 by the end of April. Shares have recently retreated towards $11 per share, which still marks a 50% fall year-over-year.

The rally in the share price has been driven by the recovery of the wider equity market as well as the commodity markets. While oil prices have rallied aggressively, at least in terms of the spot pricing, the gains in copper has been much less pronounced. While it is possible for shares to recover to their $20s if commodity prices recover further, it is important to recognize that real damage has been done.

In the period 2010-2014, when commodity prices were still relatively high, shares traded in the $40-$50 range. With roughly 1 billion shares outstanding at that point in time, equity has been valued at $40-$50 billion, while the balance sheet was relatively unleveraged. While the addition of energy assets could add $5 billion to the enterprise valuation in today's world, Freeport has been saddled with a $20 billion net debt load. That illustrates that if copper prices recover to the 2010-2014 scenario, the equity valuation for shareholders might be seen at $25-$35 billion.

This lower valuation incorporates the value being destroyed with the oil & gas acquisitions. Given the 25% dilution incurred along the way, shares might be worth $20-$28 in today's world based on the assumption that copper prices recover to levels in the period 2010-2014. While that looks attractive based on the current level in the stock, it is important to question what the chances are that copper prices return to these historical levels.

For now, Freeport is buying itself time with the liquidity provided by asset sales, as the maturity and interest rate profile of the debt is quite attractive. Liquidity puts pressure off the table to divest at a rapid pace, creating more time and optionality going forward. Despite this beneficial impact of optionality, I can conclude that real value has been destroyed with the oil & gas adventure. The added debt and dilution incurred along the way actually makes FCX less cheap as it looks based on the stock price alone.

At the moment, I would have a neutral stance, but I certainly avoid the momentum bandwagon upwards, as past highs in the share price are structurally impaired.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.